Where are we?

Second midterm on November 19, not November 14 Review questions will be distributed this week Today we finish production and move on to the chapter on perfect competition

Topic for the second paper: Pick a chapter in Ariely after Chapter 4 and compare Ariely’s analysis of the chapter’s topic to the standard model of rationality in consumer and/or producer behavior. Be sure to refer to the text for the comparison.

Add marginal cost curve to the average cost curves Relationships among cost curves

The vertical distance between ATC and AVC curves is equal to AFC, as illustrated by the two arrows.

The marginal cost curve (MC) is U-shaped and intersects the average variable cost curve and the average total cost curve at their minimum points. Explaining the shape of the ATC

The shape of the ATC curve combines the shapes of the AFC and AVC curves.

The U shape of the average total cost curve arises from the influence of two opposing forces: • Spreading total fixed cost over a larger output • Decreasing marginal returns Short run cost and product curves

As productivity decreases, costs rise.

This means that cost and product curves are reverse sides of the coin. Graph relationship between MP and MC The cost and product curve relationship graphically

A firm’s marginal cost curve is linked to its marginal product curve.

If marginal product rises, marginal cost falls.

If marginal product is a maximum, marginal cost is a minimum. Add AP and ATC

Cost and product curves

A firm’s average variable cost curve is linked to its average product curve.

If average product rises, average variable cost falls.

If average product is a maximum, average variable cost is a minimum. Three zones in relationship between cost and product curves At small outputs, MP and AP é MC and AVC ê

At intermediate outputs, MP ê MC é APé AVC ê

At large outputs, MP and AP ê MC and AVC é Shifts in cost curves

Technology A technological change that increases productivity shifts the TP curve upward. It also shifts the MP curve and the AP curve upward. With a better technology, the same inputs can produce more output, so an advance in technology lowers the average and marginal costs and shifts the short-run cost curves downward. Shifts: Prices of factors of production

An increase in the price of a factor of production increases costs and shifts the cost curves. How the curves shift depends on which resource price changes. An increase in rent or another component of fixed cost • Shifts the fixed cost curves (TFC and AFC) upward. • Shifts the total cost curve (TC) upward. • Leaves the variable cost curves (AVC and TVC) and the marginal cost curve (MC) unchanged. Variable cost changes: What do they affect?

An increase in the wage rate or another component of variable cost • Shifts the variable curves (TVC and AVC) upward. • Shifts the marginal cost curve (MC) upward. • Leaves the fixed cost curves (AFC and TFC) unchanged. Long run: All factors variable Moving to the long run  Plant Size and Cost When a firm changes its plant size, its cost of producing a given output changes. Will the average total cost of producing a gallon of smoothie fall, rise, or remain the same? Each of these three outcomes arise because when a firm changes the size of its plant, it might experience: • Economies of scale • Diseconomies of scale • Constant returns to scale Long run cost

Economies of scale exist if when a firm increases its plant size and labor employed by the same percentage, its output increases by a larger percentage and average total cost decreases. The main source of economies of scale is greater specialization of both labor and capital. Long run cost

Diseconomies of scale exist if when a firm increases its plant size and labor employed by the same percentage, its output increases by a smaller percentage and average total cost increases. Diseconomies of scale arise from the difficulty of coordinating and controlling a large enterprise. Eventually, management complexity brings rising average total cost. Long run costs

Constant returns to scale exist if when a firm increases its plant size and labor employed by the same percentage, its output increases by the same percentage and average total cost remains constant. Constant returns to scale occur when a firm is able to replicate its existing production facility including its management system. Long run average cost

The long-run average cost curve shows the lowest average cost at which it is possible to produce each output when the firm has had sufficient time to change both its plant size and labor employed. Long run average cost curve

In the long run, Sam’s Smoothies can vary both capital and labor inputs.

With its current plant, Sam’s ATC curve is ATC1. With successively larger plants, Sam’s ATC curves would be ATC2, ATC3, and ATC4. Long run average cost curve

The long-run average cost curve, LRAC, traces the lowest attainable average total cost of producing each output.

LRAC and scale effects

Sam’s experiences economies of scale as output increases to 9 gallons an hour, … constant returns to scale for outputs between 9 gallons and 12 gallons an hour, … and diseconomies of scale for outputs that exceed 12 gallons an hour. EYE on RETAILERS’ COSTS Which Store Has the Lower Costs: Wal-Mart or 7–11? Wal-Mart’s “small” supercenters measure 99,000 square feet and serve an average of 30,000 customers a week. The average 7–11 store, mostly attached to gas stations, measures 2,000 square feet and serves 5,000 customers a week. Which retailing technology has the lower operating cost? The answer depends on the scale of operation. At a small number of customers per week, it costs less per customer to operate a store of 2,000 square feet than a store of 99,000 square feet. EYE on RETAILERS’ COSTS Which Store Has the Lower Costs: Wal-Mart or 7–11? The average total cost curve of operating a store of 2,000 square feet is ATC7–11. The average total cost curve of a store of 99,000 square feet is ATCWal-Mart. The dark blue curve is a retailer’s LRAC curve. EYE on RETAILERS’ COSTS Which Store Has the Lower Costs: Wal-Mart or 7–11? With Q customers a week, the average total cost of a transaction is the same in both stores. For a store that serves more than Q customers a week, the least-cost method is the big store. EYE on RETAILERS’ COSTS Which Store Has the Lower Costs: Wal-Mart or 7–11? With Q customers a week, the average total cost of a transaction is the same in both stores. For a store that serves fewer than Q customers a week, the least-cost method is the small store. On to rofit maximization in perfect competition

 What is profit? TR – TC  What is perfect competition? No consumer or producer can influence the market price – all price takers

Concentration in US manufacturing: All companies Concentration ratios by sector Concentration ratios by sector continued Maximizing profit

How to do it?

2 methods: TR & TC and MR & MC

Maximize profit where

1. maximize difference between TR and TC or (equivalently) 2. MR = MC

Slope of the MR curve

 MR is the price paid for each additional unit

 Constant because of perfect competition

 Market price is given to all firms

 Can only sell at that price no matter how much they sell Slope of the TR curve

 Constant because MR is constant

 MR constant because of perfect competition where firm is a price taker

 Graph of the TR curve is a straight line The revenue side – marginal revenue The revenue side – total revenue Marginal and total revenue MR comes from market price. The table shows the calculations of TR and MR.

Second approach: Profit maximization through MR and MC rather than TR and TC If MR > MC, the extra revenue from selling one more unit exceeds the extra cost incurred to produce it. Economic profit increases if output increases.

The opposite holds if MC > MR. Profit maximizing level of putput

 Put MC and MR together

 Have from perfect competition and the market price the MR curve (horizontal)

 And have the MC curve shape from the previous chapter MR, MC and profit maximization graphically

First decision: find the profit maximizing output

This is the best the firm can do.

But, is it good enough?

What is profit at this profit maximizing point? Profit maximizing equilibrium: Add AC The second decision: stay open or shut down

 Temporary Shutdown Decisions If a firm is incurring an economic loss that it believes is temporary, it will remain in the market, and it might produce some output or temporarily shut down. What happens and why fixed and variable costs are important 1. If the firm shuts down temporarily, it incurs an economic loss = TFC. 2. If the firm produces some output, it incurs an economic loss equal to TFC + TVC – TR. 3. If TR > TVC, the firm’s economic loss is less than TFC. 4. So it pays the firm to produce and incur an economic loss. It can pay some of TFC even if not all. Decision rule for shutting down

So the firm produces some output if P > AVC

but shuts down temporarily if AVC > P

Because by producing any output at all it increases its losses. Shutdown point

The output and price at which price equals minimum average variable cost.

Below that point can’t set aside anything to cover fixed costs.

Better to shut down. Shut down point graphically